Statements from two key policymakers in the past week have re-triggered the debate on whether India should consider full capital account convertibility. While the RBI Governor Raghuram Rajan has expressed the hope that India will get to full convertibility “in a short numbers of years”, Minister of State for Finance Jayant Sinha has stated that capital account convertibility was important for India to find a place among the top three or four global economies. While neither statement implies that India is rushing to dismantle capital controls, their timing does leave one wondering, considering the poor state of preparedness of the Indian economy for full convertibility at this juncture. After all, both the RBI and the Centre have spent much of the past year fretting about the impact of the US Federal Reserve’s impending rate hikes on capital flows. The rupee, bond and stock markets have shown a tendency to panic every time the Fed has hinted at the hike. As things stand, we don’t have a financial market that is well-placed to take unfettered capital flows in its stride.

Lessons from the Asian financial crisis of 1998 suggest three pre-requisites for a developing country to benefit from full convertibility — a comfortable current account balance, low external debt and a strong banking system that is resilient to global contagion. None of these conditions exist in India today. Yes, the current account and exchange rate have made a significant recovery from crisis levels of July-August 2013. But the improvement owes more to the fortuitous decline in global oil prices than to strong exports or a structural shift in the trade balance. Also, relative stability in the exchange rate has been brought about through frequent RBI policy interventions over the last two years — curbing gold imports, restricting forex trades and regulating foreign flows into the debt markets. These are precisely the kind of interventions that will be impossible once India adopts full capital account convertibility. On external debt, the Centre may not be exposed to currency risks given its modest foreign borrowings. But the same can hardly be said for India Inc, the overseas borrowings of which have been ballooning without check. As the bulk of these loans are unhedged, any sharp bout of currency depreciation can trigger defaults. The Indian banking system too is not in the best of shape, with large bad loans eroding the capital base of leading banks.

The primary benefits that India is likely to reap from full capital account convertibility are stronger capital flows into domestic projects, lower borrowing costs for firms, and currency diversification benefits for businesses and investors. Foreign investors already enjoy full convertibility on most transactions, while rules for Indian firms to make cross-border acquisitions or borrowings have been progressively relaxed in recent years. It is only for individuals that outward remittances remain significantly restricted. Therefore, the way forward would be to continue with a gradualist approach towards dismantling capital controls.

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